Waterfalls, this is a fun title for something so simple. A waterfall is basically how profits will be broken down and divided among investors and a sponsor in a syndication. When sponsors put together an apartment syndication deal, they make their money by splitting cash distributions with the limited partners (passive investors in the deal).
Here is a Simple Example:
A Sponsor is offering a 7% preferred return and a 80% / 20% split of profits above the preferred return. All distributions are paid to equity holders until the initial investments are returns, and moving forward LP’s will receive 80% of distributions, and the remaining 20% will go to the sponsor as a “promote”
Promote is basically the sponsor’s disproportionate share of profits in a real estate deal above a predetermined return threshold.
Let’s talk more about preferred returns. Preferred returns are basically a minimum rate of return before the sponsor gets to enjoy any split of the cashflow. Preferred returns are not guaranteed, but it is the preferred return for investors within the waterfall structure of the deal. Preferred returns must be met before the sponsor can earn their portion of the waterfall. It incentivizes the sponsor to meet and beat expectations. You can calculate preferred returns by multiplying the capital invested by the preferred return rate. You should always review the partnership agreement to learn more about the nuance of the preferred return.
Once the preferred return is met, there is a cash flow split above the preferred return. This is where the waterfall model within the partnership agreement determines what happens. A couple of things could happen. The surplus is distributed to investors to return their capital, or a split between the investors and the sponsor will happen (like our 80/20 example above)
There are many ways in which deals and funds can be structured. Some examples are a return of capital after preferred returns, or return of capital before preferred returns. For the purpose of this blog, we will keep it simple. Later we will break down some of these other structures in much more detail. Be sure to follow us on youtube and other social channels as we create more content.